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Mongolia’s coal resources have thrust the world’s least densely populated country into the midst of geopolitical diplomacy.

Dealing with the current coking coal market downturn is just one concern for Mongolia’s national coal mining company, Mongolian Mining (MMC) (HKEX:0975). MMC’s stock value has dropped 25 percent this year on slowing Chinese demand; coking coal prices have fallen as much as 15 percent in the last six months.

But the fact that Mongolia is a landlocked country, located between Russia and China, adds a whole other dynamic to the development of its coal resources.

MMC is confident that Chinese demand will return, and plans on investing US$800 million into a rail line that will help double coking coal exports to China by 2015. The company is looking to double 2011 output at its Ukhaa Khudag mine at the Tavan Tolgoi deposit by 2013.

China’s influence over the country’s coal development is seen as a blessing and a curse by Mongolia’s government. The country’s newly-minted foreign mining investment laws are aimed at limiting foreign shares in mining operations to 49 percent – unless parliamentary approval is received – due to fears that the country’s emerging democracy could be compromised by foreign powers; China, specifically.

In mid-April, Vancouver-based miner Ivanhoe Mines (TSX:IVN,NYSE:IVN) announced that it reached a takeover bid for its subsidiary SouthGobi Resources (TSXV:SGQ) from state-owned Aluminum Corporation of China (CHALCO) for US$889 million. The deal will give CHALCO up to a 60 percent share of Vancouver-based SouthGobi, above the 49 percent threshold.

At the end of June, Mongolian authorities asked SouthGobi to suspend production as they review CHALCO’s plan to acquire a majority stake in SouthGobi from Ivanhoe. The takeover bid deadline has since been bumped from July 5 to August 3, SouthGobi said in a news release.

Mongolia’s Chinese paradox

While China’s massive coal market appears to be a logical partner in developing Mongolia’s reported 5 billion tonnes of coal, the country’s political past has left it leery of leaning too heavily upon one country.

During the 20th century, the country yo-yoed between being dominated by the Soviet Union and being influenced by the Chinese Qing Dynasty. It is only in the last decade that the country has gained political autonomy, increasing transparency and freedom through democratic reforms and lively elections.

Current elections are illustrating that the world’s fastest growing economy wants to ensure that its mineral wealth – currently 80 percent of its exports – stays within the country.

The table was set for a showdown over potential resource nationalism in October of last year, when the Mongolian government said it wanted a greater share of the massive Oyu Tolgoi project – considered one of the richest copper-gold deposits in the world. The mine is being built by Ivanhoe Mines, which owns 66 percent.

Mongolia’s shared border with China has made its southern neighbor a fast friend again as all of its coal exports have gone to China through new and old paved highways and rail lines. The result so far has been increased integration of the two economies, not the development of economic autonomy that Mongolia desires.

Chuluuntseren Otgochuluu, director of Mongolia’s Economic Policy and Competitiveness Research Center, told Reuters that mining has only made Mongolia “far more integrated with the Chinese economy than the domestic economy.”

Efforts to diversify away from China have led the country to seek international suitors for its estimated 900 million tonne Tavan Tolgoi coal deposit, the world’s largest untapped source of coking coal. But, potentially reflecting Mongolia’s mining fate, the frontrunners thus far have been US-based Peabody Energy (NYSE:BTU) and Chinese state-owned Shenhua Energy. Both companies have received strong diplomatic support from their respective governments.

Attempts have also been made to include Russian interests, and a Russian-Mongolian consortium headed by Russian Railways is another bidder for the rights to buy into Tavan Tolgoi. Mongolia’s northern neighbor is also aware of the influence it holds with the country, a reality not lost on Mongolia’s government.

Puntsag Tsagaan, a presidential advisor on mining in Mongolia, commented, “[w]e’re a small country sandwiched between two elephants. We can’t go to war and fight, so we have to secure our economic growth through diplomacy.”

Securities Disclosure: I, James Wellstead, hold no direct investment interest in any company mentioned in this article.